Aviva 2006 Annual Report Download - page 202

Aviva plc
Annual Report and Accounts 2006 198
Notes to the consolidated financial statements continued
50 – Risk management continued
(b) Market risk
Market risk is the risk of adverse financial impact due to changes in fair values or future cash flows of financial instruments from
fluctuations in interest rates, equity prices, property prices, and foreign currency exchange rates. Market risk arises in business units
due to fluctuations in both the value of liabilities and the value of investments held. At Group level, it also arises in relation to the
overall portfolio of international businesses and in the value of investment assets owned directly by the shareholders.
The Group has established a policy on market risk which sets out the principles that businesses are expected to adopt in respect of
management of the key market risks to which the Group is exposed. The Group monitors adherence to this market risk policy and
regularly reviews how business units are managing these risks locally, through the Group Investment Committee and ultimately to the
Asset Liability Management committee. For each of the major components of market risk, described in more detail below, the Group
has put in place additional policies and procedures to set out how each risk should be managed and monitored, and the approach to
setting an appropriate risk appetite.
The management of market risk is undertaken in both business units and at Group level. Business units manage market risks locally using
their market risk framework and within local regulatory constraints. Business units may also be constrained by the requirement to meet
policyholders’ reasonable expectations and to minimise or avoid market risk in a number of areas. The Group Investment committee is
responsible for managing market risk at Group level, and a number of investment related risks, in particular those faced by the
shareholder funds throughout the Group.
The financial impact from changes in market risk (such as interest rates, equity prices and property values) is examined through stress tests
adopted in the Individual Capital Assessments (ICA) and Financial Condition Reports (FCR), which both consider the impact on capital
from variations in financial circumstances on either a remote scenario, or to changes from the central operating scenario. Both consider
the management actions that may be taken in mitigation of the change in circumstances.
The sensitivity of Group earnings to changes in economic markets is regularly monitored through sensitivities to investment returns and
asset values in EEV reporting.
The Group market risk policy sets out the minimum principles and framework for matching liabilities with appropriate assets, the
approaches to be taken when liabilities cannot be matched and the monitoring processes that are required. The Group has criteria
for matching assets and liabilities for all classes of business in order to manage the financial risk from the mismatching of assets and
liabilities when investment markets change. The local regulatory environment for each business will also set the conditions under which
assets and liabilities areto be matched.
Equity price risk
The Group is subject to equity price risk due to daily changes in the market values of its equity securities portfolio. The Group’s
shareholders areexposed to both direct equity shareholdings in its shareholder assets, from the indirect impact from changes in the value
of equities held in policyholders funds from which management charges or a share of performance are taken, and from its interest in the
free estate of long-term funds.
At business unit level, equity price risk is actively managed in order to mitigate anticipated unfavourable market movements where
this lies outside the risk appetite of the fund concerned. In addition local asset admissibility regulations require that business units hold
diversified portfolios of assets thereby reducing exposure to individual equities. The Group does not have material holdings of unquoted
equity securities.
Businesses actively model the performance of equities through the use of stochastic models, in particular to understand the impact of
equity performance on guarantees, options and bonus rates.
The Investment Committee actively monitors equity assets owned directly by the Group, which may include some material shareholdings
in the Group’sstrategic business partners. Concentrations of specific equity holdings (eg the strategic holdings) arealso monitored
monthly by the Capital Management Committee.
Asensitivity to changes in equity prices is given in section (g) below.
Property price risk
The Group is subject to property price risk due to holdings of investment properties in a variety of locations worldwide. The investment
in property is managed at business unit level, and will be subject to local regulations on asset admissibility, liquidity requirements and the
expectations of policyholders. At 31 December 2006, no material derivative contracts had been entered into to mitigate the effects of
changes in property prices.
Asensitivity to changes in property prices is given in section (g) below.
Financial statements continued